Why Does Wall Street Make So Much Money, Anyway?

Income inequality is rising most sharply at the very top, among the very guys who nearly brought the economy down

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Why do Wall Street guys make so much more money than the rest of us? Income inequality is rising in the U.S., and the gap is sharpest among the super rich. A little of this is sports stars with outlandish contracts, sure. But a lot of it is the financial sector, Tyler Cowen writes at The American Interest. And that's troubling. There's the debate over whether these gaps cause financial crises. Then, though, there's also this question: How does the financial sector rake in all that dough to begin with?

Cowen points to two factors. The first, "going short on volatility," basically "means that some investors opt for a strategy of betting against big, unexpected moves in market prices." This works very well until it doesn't. Cowen explains that it's like betting every year that a crappy basketball team won't win the NBA title--every once in a while you lose big. Wall Street is doing this, and worse, it's doing it with other people's money, which means even if a disaster happens, and money managers get fired, they still make off with millions. The second factor is called "moving first"--traders are rewarded for being the first to act on some bit of news. Together, those issues mean that a big, wealthy firm like Goldman Sachs can go short on volatility faster and better than everyone else, and in most years, it's no big deal. "Yet over time this situation will corrode productivity, because what the banks do bears almost no resemblance to a process of getting capital into the hands of those who can make most efficient use of it," Cowen writes. Here's how others are weighing in:

  • How Did They Get This Much Cash in the First Place? Mother Jones' Kevin Drum wonders.
There are three possibilities: (1) banks created it, (2) their activities caused the economy to grow faster than it otherwise would have, and they reaped the benefit of that extra growth, or (3) it was somehow skimmed away from the rest of society. Possibility #1 is unlikely: banks certainly created mountains of debt, but mountains of money would show in skyrocketing monetary aggregates and high inflation, neither of which happened. Possibility #2 also seems unlikely. There's simply no evidence, either in comparisons over time or comparisons between countries, that economic growth over the past two or three decades has benefited from financial rocket science. So that leaves possibility #3: somehow, all this financial engineering was based on skimming money away from everyone else.
  • It's Just Easier to Cheat, Tim F. responds at Balloon Juice. "To answer Kevin, finance is incredibly profitable because the finance sector has a greater information asymmetry between buyers and the sellers than almost any other sector on Earth. ... At the same time deregulation made it that much harder to catch cheaters and also opened vast new opportunities for semi-legal schemes as well as the nakedly illegal kind."
  • Note The Other Side of the Bet  "The essay talks about how the financial sector goes 'short on volatility', which is a bet that things won't go crazy in the short term, or a bet that takes on tail risk," Mike Konczal writes at Rortybomb. "As Kevin Drum mentions someone is on the other side of that bet.  And what do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is 'insurance.'" This insurance-style setup is a big part of the equation.
  • A Good Bet Even Without Bailouts, Matt Yglesias argues. "Richard Fuld and other Lehman Brothers honchos didn't get bailed out. But Fuld and other key Lehman executives still earned far more than most Americans during the good years, and even those who are still unemployed today are far richer than the average American. Looking back on the whole saga in retrospect, I'm sure they wish they’d gotten a bailout or somehow manipulated the situation a bit better. But if the alternative to getting rich and then going bust was to never get rich in the first place, then the alternative looks bad even without bailouts."
  • It's 'Terrifically Hard' To Figure Out What to Do About It  "We can easily treat symptomatic inequality through progressive redistribution, but this won't cure our deeper institutional malady," writes Will Wilkinson at The Economist. " The deeper problem is that Wall Street can and continues to drink our milkshake--that there is a draining hole in the social till that has already caused our economy to collapse once--not that the banker's portions of milkshake are growing faster than ours."
  • There Has to Be a Way to Fix This, The New York Times' Ross Douthat writes. He notes that Cowan has argued for killing banks that are too big to fail. What if we were simultaneously to shrink the national debt and the huge banks that fund it? Douthat asks.
I understand that this is not the most politically realistic conceit, since it would require some sort of progressive-conservative alliance in the service of policies that (as Cowen notes) most voters reject in favor of the more appealing combination of 'high government spending and relatively low taxes.' But it seems like the approach that’s implied by his arguments. And I wonder if it’s better to advance politically unrealistic solutions, in the hopes of making them more realistic, than to give up and accept a system that’s all-too-likely, in Cowen's words, to 'again bring our economy to its knees' as 'the price of modern society.'
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